Email from Len Sherman, Adjunct Professor, Columbia Business School

Robert, I read with great interest your recent blog post demonstrating the relatively low ROI’s  required to replicate EPS growth from equivalent share buybacks.  Your analysis suggests profound flaws in the two most common rationales corporate executives give for their share buyback programs

  1. Our actions reward shareholders by making their shares more valuable
  2. Our stock is undervalued. Our actions reflect management’s confidence in our growth potential

The first argument may be true for EPS, but not for long term stock price appreciation. The second argument is even more galling, as your analysis suggests exactly the opposite.  Given your results, the only logical explanation to go ahead with an aggressive buyback program is that management actually doesn’t  believe it can generate even modest returns on its cash from current operations.  Or said another way, management is in essence saying they are giving money back to shareholders because they have run out of ideas on how to generate attractive returns within the company.  Or course, the more likely explanation for share buybacks is  management bonus kickers based on EPS.  So much for CEO’s and boards acting in the best interest of shareholders.

I teach business strategy in the MBA program at Columbia Business school where I share a perspective that effective capital allocation is one of the most important responsibilities of the CEO.  To illustrate the point, I point to IBM who has skewed its use of capital (including debt financing) towards share buybacks at the expense of value-creating investments in R&D and capex.  As a result, IBM’s R&D lags its technology peers, and not surprisingly (despite aggressive acquisition activity), its revenues have declined for 15 straight quarters.  The attached figure graphically depicts these trends.

HP is another case of the folly of favoring share buybacks over R&D in the tech industry.  Carly Fiorina is often criticized for her disastrous acquisition of Compaq, but her successor Mark Hurd also deserves notoriety for slashing HP’s R&D expenditures while sizably expanding HP’s share buyback program.

Shareholders who maintained their investments in both of these companies through their periods of substantial share buybacks have not fared well.

I’d be curious to learn whether you’ve done any analysis tracing the stock price performance (relative to the S&P 500) of companies who have been most active in stock buybacks.  Has management unwittingly practiced buy high/sell low?!

Len Sherman

Columbia Business School

Attachments area

March 27th 2016

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